Short Sale Tax Break Ending

Dec 10, 2012 by

Sale pending real estate signIn general, the IRS considers forgiven debt as income to the party relieved of the debt (a fact many fail to factor into a debt settlement plan—but that’s another article). That means the beneficiary of a forgiven debt must consider the amount forgiven as income when preparing the year’s federal income tax return.

With millions of homeowners underwater on their mortgages—meaning their homes are worth less than the outstanding mortgage balance—the 2007 Mortgage Forgiveness Debt Relief Act eased the burden on underwater homeowners and facilitated short sales by making tax-free mortgage debt forgiven through a short sale. Originally set to end on 31 December 2009, our esteemed elected officials extended the Act once—by three years—so it now expires at the end of 2012. Unless it’s extended again by fiscal cliff preoccupied politicians, forgiven mortgage debt will again become taxable effective 01 January 2013.

What’s a Short Sale?

Let’s say you owe $100,000 on your mortgage, but after the housing crash of the past several years, the house for which you paid $135,000 eight years ago is now worth about $85,000, according to your realtor. You want to relocate to a better job market, but if you sold your house for $85,000, you’d have to come up with $20,000 cash out of your own pocket to add to the net sale proceeds of $80,000 (after the realtor takes her cut) to pay off your $100,000 mortgage. You don’t have $20,000 cash, so you’re stuck.

On your realtor’s advice, you visit your mortgage lender and strike a deal to make a short sale: Sell your house for $85,000 or more, and the lender will forgive 75% of the difference between your mortgage balance and the sale price. (What’s the lender’s motivation? Avoiding adding your mortgage to what’s likely a very large pile of costly foreclosures already in its queue.) You can scrape together enough cash to cover the 25% of the short amount not forgiven, so you put your house on the market and hope for the best.

Your House Sells Short—Now What?

Leaving out a lot of potentially messy detail here, your house sells for $89,000, netting you $83,500 after selling costs. You’ve made a few mortgage payments while your house has been on the market, so the balance at closing is $98,500. That means:

→ Amount your lender will forgive = ($98,500 mortgage balance – $89,000 gross sale proceeds) × 75% = $7,125

To meet your part of the deal, you have to fork over at closing $2,375. So the lender gets

→ $89,000 gross sale proceeds + your $2,375 in cash = $91,375

After closing, you’re off the hook for the $98,500 mortgage balance.

Short Sale Tax Consequences

If all this happens before year’s end, you won’t owe federal income tax on the $7,125 forgiven debt. But if the tax break isn’t extended, and if your marginal federal income tax rate is 15%, the same sale occurring after December 31 would result in federal income tax liability of:

$7,125 forgiven debt × 15% tax rate = $1,069

This is additional tax you’d owe when you filed your 2013 return because of the short sale’s forgiven debt. Of course, unlike your earned income, “forgiven debt income” is rather ghostly, since you didn’t really get $7,125 in cash from which you could draw the $1,069 in tax. Unless you’ve got a fat refund coming, you have to come up with an extra $1,069 from your savings when you pay your tax bill.

What to Do

Given that the year’s about over, it’s too late to make a short sale happen in 2012 unless you’re well into the process. All you can do is write your congressperson and urge extension of the tax break.

But if you’ve already negotiated a short sale deal with your lender and your house is on the market, it can pay to expedite any potential sale of the house, if possible. Depending on the tax savings, you could accept in 2012 a lower price for your house and still come out ahead, net of your tax liability, compared to a 2013 sale.

Have You Done a Short Sale?

If you’ve sold a home through a short sale in the past few years, how much tax do you figure you saved due to the 2007 Mortgage Forgiveness Debt Relief Act? Are you pushing to make a short sale happen before year’s end? If so, how?

What do you think is the likelihood the tax break will be extended past the end of this year? (You might ask your congressperson; personally I have considerably better luck forecasting Yahtzee dice rolls than I do predicting what politicians will do.)

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